Fed hits pause, but December looms

Why not now? Fed holds rates steady

• No surprise in today’s decision. The Fed was widely expected to hold rates steady, and it did. The more interesting question is: Why not raise rates now?
• The economic backdrop makes a reasonable case for another hike:
  • Inflation remains well above the Fed’s 2% target, and recent inflation readings have been hotter than policymakers would like.
  • Economic growth remains strong.
  • Consumer spending has been resilient.
  • Business investment, particularly AI-related capital spending, remains robust.
  • Labor market conditions remain broadly stable.
  • Housing is a notable weak spot, but there’s little evidence that the broader economy is buckling under the weight of higher rates.
• There are legitimate reasons for the Fed to wait. A portion of the recent inflation pressure reflects higher energy prices and geopolitical disruptions. Monetary policy is a blunt instrument for addressing supply shocks. Higher interest rates can restrain demand, but they can’t produce more oil or resolve geopolitical instability. That’s far from the only source of inflation, but it’s a material contributor.
• The question is whether those pressures remain temporary and contained. Higher energy costs are already showing signs of filtering into core goods and food prices. What begins as an energy shock can become broader and stickier if it affects business pricing, wages, and inflation expectations. That’s a real and growing risk.
• AI investment creates an unusual near-term/long-term tradeoff.
  • The massive buildout of AI infrastructure is adding to demand today and is inflationary in the near term. Over the intermediate term, however, the expected productivity payoff could help to ease price pressures.
  • If those productivity gains materialize, a key benefit could be a disinflationary impulse, even in the absence of higher policy rates.
  • The big questions are how meaningful those productivity gains will be and how quickly they will become apparent.
• The bond market may also be doing some of the Fed’s work for it. Higher long-term interest rates and a greater uncertainty premium embedded further out the yield curve have tightened financial conditions beyond the effect of the September rate hike. That raises borrowing costs and restrains interest-sensitive activity.
• Put those pieces together and an argument for the Fed’s patience becomes more understandable. Policymakers may be betting that some combination of higher long-term rates, fading supply pressures and improving productivity can do part of the work that another rate increase otherwise would.
• But none of those outcomes is guaranteed. If productivity gains arrive later or are smaller than anticipated, energy pressures persist, or strong demand keeps inflation elevated, the Fed risks moving too slowly or waiting too long and allowing inflation pressures to become more deeply embedded in the economy.
• A hike today wouldn't have immediately solved the inflation problem. Monetary policy works with significant lags. The effect of another quarter-point increase would take considerable time to fully work its way through the economy. That gives the Fed some rationale for gathering more information before acting, but it also raises the risk that patience works against them if economic momentum is sustained and price pressures build.

December increasingly looks like the answer

• Whatever their rationale, today’s decision raises the stakes for the Fed and makes their December policy decision even more critical.
• Fed funds futures indicate a roughly 90% probability of another quarter-point hike by December.
• The Fed’s own language makes another hold increasingly difficult to justify if the inflation data remain firm. Policymakers explicitly acknowledge that inflation remains elevated while reiterating their commitment to returning inflation to 2%.
• That leaves two basic possibilities: either market-driven financial tightening and prospective productivity gains will do enough of the heavy lifting, or additional Fed tightening is coming.
• My expectation is the latter. The Fed won’t promise a December hike, and Fed Chair Warsh will understandably endeavor to preserve the Fed’s optionality. Still, a December hold would become increasingly difficult to square with a strong economy, persistent inflation, and a forceful commitment to restore price stability.
• Credibility increasingly becomes part of the equation. If inflation remains elevated and the Fed repeatedly acknowledges the problem but chooses not to act, markets will reasonably begin asking what economic conditions would actually trigger another increase. Absent some easing of inflation pressures in relevant data between now and the next FOMC meeting, the likelihood of a December quarter-point hike appears high.

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